Blackthorn Quarterly Letter April 2018


For some time we have been warning about a melt up in the markets. The stage had been set for asset prices to roar higher. Well, 2018 came roaring in like a lion with, what appears to be, the late stages of a market melt up.  At its zenith the S&P 500 was up almost 7.5% for the month! The incredible start to 2018 was clearly unsustainable and it was obvious that some sort of correction in 2018 was likely. February was clearly much different than January, in that, the S&P 500 that we had come to enjoy over the last 13 months had now turned south.  The volatility quake of February was just what the market needed to wake it from its relentless sleep walk higher. While we have enjoyed the last 9 quarters of positive pricing it was just a matter of time before markets reverted closer to their historical glide path

While we have made note in our letters of historically elevated valuation metrics we see further anecdotal evidence of that elevated pricing in legendary investor Warren Buffett’s latest Annual Letter. Buffett is well known to be constantly on the search for deals in the marketplace. His job is to allocate capital and he does that in buying stocks in companies or preferably entire companies as he adds to his portfolio. One of the main challenges in running Berkshire Hathaway is consistently putting newly acquired capital to work as it is a capital generating machine. In his latest annual address he notes that prices for assets are challenging. He described that finding a deal ata sensible purchase price” has become a challenge”.Berkshire Hathaway Annual Letter 2/26/2018

Why are prices so elevated? As you know from our writings, it is our opinion that elevated prices are directly related to central bank policy around the globe. A policy that, if even spoken of in polite circles a decade ago, would have gotten you laughed out of a room of economists. This past decade has been filled with rising asset prices due to the fire hose of central bank policy. Historically low interest rates, growing balance sheets, and low volatility all combined in excel spreadsheets to justify higher valuations for assets.

This never before attempted policy is now being seen by central bankers as being long in the tooth. Central bankers are now enacting tighter policy if only to have “bullets in the gun”. There is always another crisis and policymakers know they will be expected to respond. Policy maker’s response to the next crisis would be limited in scope if interest rates are along the zero bound and they hold an inordinately large balance sheet. Federal Reserve officials have been more overt in their recent communications that they are concerned about having the capacity to respond to a crisis in the future.

“Long-term risks include reduced capacity of both fiscal and monetary policy to act against downturns. Eric Rosengren Boston Fed President speech 4/13/18

What Changed?

What has changed is the tax cut. The tax plan really started in the middle of September and that’s when you saw the bond market reacting. …At that point, the market had shifted from its disinflationary mindset to a moderate inflation mindset. And that’s the repricing that has been taking place. Jeff  Sherman CIO Doubleline Funds

Central bankers are right to be concerned as the market perceives a change in mindset. Change can create volatility. Volatility can create fear. Fear can manifest itself in a lack of faith in the Fed to maintain stability. Instability creates lower asset prices.  Investors are seeing inflation on the horizon for the first time in a decade and that necessitates a rotation into a different investment game plan. Currently, investors are walking a tightrope between investing for inflation and investing for deflation. A deflationary game plan includes investing in longer term bonds and buying stocks when central bankers inject capital. An inflationary game plan includes commodities, low duration bonds and equities when inflation is controlled. We are walking a tightrope of investing options as the two outcomes are polar opposites.

“We have to deal with the possibility that at one point the Fed and other central banks may have to take more drastic action than they currently anticipate” and rates “may go higher and faster than people expect.” – JP Morgan CEO Jamie Dimon Annual Letter 2018

Ironically, the next crisis will probably be caused by the central banker’s actions (or inactions) as they try to pare down their balance sheets and normalize interest rates.

Until Something Breaks

And if you respect financial history, what the Fed has always done is hike until something breaks. We definitely had the debt build up. Looking at debt to GDP, people talk a lot about a bond bubble. But it’s not in the treasury market and it’s not in the housing market. It’s in Corporate America – Jeff Sherman CIO Doubleline Funds

What could break? We surmise that it may be the corporate debt market. Currently the 2 year US Treasury is the highest it has been since 2008 and if interest rates continue to rise there is concern that corporations may not be able to refinance debt that is coming due in the next two years. The artificially low interest rate regime that has prevailed since the GFC has given rise to zombie companies. Zombie companies are corporations that would have otherwise, with normalized interest rates, not been able to refinance their debt and stay alive. Those companies may not be able to stay afloat with rising interest rates and with less access to capital. That could create a significant drag on the economy as they close their doors. An additional concern is the rising share of the US budget that is being outlaid to interest payments. If rates were to normalize then the US budget is in danger of becoming a slave to its interest payments. That is the cross for the Federal Reserve to bear. How much is tightening is too much? How much can they tighten before something breaks?

Asset prices, which have risen on the back of loose central bank policy, should now, theoretically, reverse given central bankers current goal of tightening monetary policy. Central bankers are walking a fine line when trying to reverse their experimental policy. The trick here is for central bankers strike a balance where they are able to rein in policy without collapsing asset prices.

One of the biggest keys to success in this environment will be how the Fed responds to the markets’ response to any change in policy. If the market falls into a bear market a key driver will be how the Federal Reserve responds to any market correction. That response is likely to determine how long and how deep any correction might be. Our first clues may not come from the equity market as to markets overall response but from the bond market. Bond yields may be the risk temperature gauge for markets. Rising/falling bond yields or a continued flattening of the yield curve may portend equity market action.

“Spreads between corporate bonds and 10-yr Treasuries has fallen to relatively low levels, notes studies have showing investor confidence that generates low credit spreads often precedes subsequent economic reversals.” – Eric Rosengren Boston Fed President

The rising specter of inflation may have been the initial culprit of the recent sell off in February but that is normal for this late in the cycle. Pundits are saying “but the economy is doing so well”. The reason markets sell off when the economy is doing well is due to the central bank and its efforts to maintain a balance between prices and a strong economy. If the economy is doing well central banks will raise rates to slow the economy as inflation begins to rise. The reverse is true as well. If deflation arises and the economy is performing poorly central banks will lower rates to stir the economy and its concerns about inflation go on the back burner.

Then the acceleration of demand into capacity constraints and rise in prices and profits causes interest rates to rise and central banks to tighten monetary policy, which causes stock and other asset prices to fall because all assets are priced as the present value of their future cash flows and interest rates are the discount rate used to calculate present values. That is why it is not unusual to see strong economies accompanied by falling stock and other asset prices, which is curious to people who wonder why stocks go down when the economy is strong and don’t understand how this dynamic works. -Ray Dalio Bridgewater Associates

We continue to believe that central bank purchases will dictate asset pricing and while we can try and predict when asset flows will turn negative we cannot predict when markets will react to that reversal in flow. Buy the dip may have turned into sell the rip. The 3% level on the 10 year is the key. Equity markets continue to tumble whenever bond yields rise and bond yields fall whenever equity markets stumble. We are stuck in a loop. Markets may be stuck in neutral until central bankers either stop tightening or tighten too much.

 What’s Next

For one thing, I’m convinced the easy money has been made.  … the one thing we can say for sure is that the current prospects for making money in U.S. equities aren’t what they were half a dozen years ago.  And if that’s the case, isn’t it appropriate to take less risk in equities than one took six years ago? – Howard Marks Co-Chairman Oaktree Capital 1/23/2018

The lack of volatility in recent years has led to a one way market – up. So far in 2018 we have seen the return of volatility that has been missing from market advances in recent years. As we see a rise in the fear gauge we expect a repricing of assets and, with that, markets are going to be increasingly volatile and move in two ways- both up and down- rather than what we have seen over the last 9 quarters. While it may become more difficult to make money in this environment we feel that opportunities will present themselves to readjust asset allocations to our benefit. In the past 25 sessions, as we write, we have seen the Dow move triple digits in 21 of those sessions. While that may offer opportunities it also may indicate that something is not quite right under the surface. How do we position ourselves at the current time when it comes to equities? Here is some advice from Benjamin Graham, Warren Buffett’s mentor.

We can urge that in general the investor should not have more than one half in equities unless he has strong confidence in the soundness of his stock position and is sure that he could view a market decline of the 1969-70 type with equanimity. It is hard for us to see how strong confidence can be justified at the levels existing in early 1972. Thus, we would counsel against a greater than 50% apportionment to common stocks at this time. -Benjamin Graham The Intelligent Investor

 From Graham’s perspective he saw a massive run higher in the Dow Jones from 1942 -66 and, subsequently, saw markets struggle in 1969-70 period. The move lower from 1969-70 totaled a 35% loss in equities. That is the kind of loss Graham is talking about. Graham’s lack of confidence in 1972 was well founded as a massive bear market would take place from 1972-74.

We wholeheartedly agree with Graham as to strategy. We also think that Graham would agree with us on the market’s current position and the highly elevated valuations that we see today. We are not saying that a massive bear market is around the corner. What we are saying is that equities are at historical valuations. Is it not prudent to take less risk in equities than one took 6 years ago? The current markets may consolidate and then move higher still but we are not willing to bet the farm on that. We expect a long period of consolidation and a move higher or a shorter period of consolidation and a move lower. We must position accordingly.

Emotional Capital

We have spent a good deal of time lately talking to clients about emotional capital. When cycles reach a more mature stage it is prudent to sell some winners and build a cash (and emotional) cushion with which to buy future bargains. That way when market losses come you are keenly aware that you prepared for this moment and this money was set aside to buy assets at bargain prices. If you are holding too much in the way of assets when they begin to fall you will be tempted to start selling. It is then that you will be managing your money from an emotional point of view.


First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. – Warren Buffett

As investors, our job is NOT making the case for why markets will go up. Making the case for why markets will rise is a pointless endeavor because we are already invested. If the markets rise, terrific. We all made money, and we are the better for it. However, that is not our job. Our job, is to analyze, understand, measure, and prepare for what will reduce the value of our invested capital. –Lance Roberts



I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein CEO of Goldman Sachs


Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks…During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.Warren Buffett


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Suwanee, Georgia 30024






Disclosure: According to SEC Custody Rule 206(4)-(a)(2), Blackthorn urges you to compare statements/reports initiated by your Blackthorn with the Account Statement from the custodian of your account for data consistency. To that end, if you find any discrepancy between these reports and the statement(s) that you received from your account’s custodian, please contact your Advisor or custodian. Also, please notify your Advisor promptly if you do not receive a statement(s) from your custodian on at least a quarterly basis.

Blackthorn is an investment adviser registered in the state of Georgia. Blackthorn is primarily engaged in providing discretionary investment advisory services for high net worth individuals.

All information provided herein is for informational purposes only and should not be deemed as a recommendation to buy or sell securities. All investments involve risk including the loss of principal. This transmission is confidential and may not be redistributed without the express written consent of Blackthorn Asset Management LLC and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential offering memorandum.

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One CommentLeave a comment

  1. Excellent piece, TR..

    On Sun, Apr 15, 2018 at 2:09 PM, Terence Reilly’s Wall Street Blog wrote:

    > TerenceReilly posted: ” Roaring For some time we have been warning about a > melt up in the markets. The stage had been set for asset prices to roar > higher. Well, 2018 came roaring in like a lion with, what appears to be, > the late stages of a market melt up. At its zenith the S” >

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